How are Disability Insurance Policies Taxed?
The general rule for owners and beneficiaries of disability insurance policies is this: If you take a tax deduction for the premiums, then the income from a disability insurance policy is taxable.
For example: If you are the beneficiary of a workplace disability insurance plan, and your employer pays the premiums (and takes a tax deduction for these premiums as an employee compensation business expense), then any income paid to you is taxable as ordinary income.
However, individuals who buy disability income insurance policies generally cannot take a tax deduction for the premiums. Since they do not take a tax deduction, but instead pay their premiums with after-tax dollars, then income benefits paid out to the beneficiary or policy owner are generally tax-free.
The same principle applies if the employer pays a portion of the premiums (taking a business expense deduction) and the employee pays a portion. The employee is not entitled to take a tax deduction on the premiums because the IRS considers the premiums a personal expense to the employee. If the policy pays a benefit, then the employee must pay income tax on a pro rata portion of the benefit. That is, if your employee pays 50 percent of the premium, you must pay income tax on 50 percent of the benefit.
Note: IRS regulations require the calculation to be made based on an average of premium payments going back over three years.
Section 125 (Cafeteria) Plans
If the employer pays a portion of the premium and the employee uses pre-tax dollars to pay for the remainder of the premium then the employee must pay income tax on 100 percent of the benefit. Note that the principle holds throughout - the employee did not pay taxes, in this case, on any of the money used to pay the premiums, and therefore is not entitled to shield the benefit from federal taxes.
In short, if you take a tax benefit on the front end, you have to pay the full income tax bill on the back end - if the plan, in fact, pays benefits.
Owner/Employees of C Corporations
If you are a C corporation owner/employee, you can choose to have your corporation take the tax deduction now or simply own the policy personally. If the corporation pays the premiums, benefits are taxable to the owner/employee.
Like corporation owner/employees, you also have the option of treating premiums as a tax deductible employee compensation expense, or owning the policy personally and paying premiums with after tax dollars. The same basic principle applies as in the above cases, however: If you took a deduction on the premium, benefits are taxable as ordinary income.
Owners of partnerships (partners) are not generally considered to be employees in the same sense that owner/employees of corporations are. The same applies to S corporations that are taxed as partnerships as well as members of limited liability companies. In these cases, while premiums paid to cover employees are deductible (and benefits to these employees are taxable), any costs for insurance for owners gets passed along to their gross income on their personal returns. They don't get to deduct for the premiums, and neither does the partnership. In these cases, benefits are generally income tax-free.
Proceeds from workers compensation insurance programs are generally tax-free, if paid under a workers compensation act in your state.
Railroad sick pay under the Railroad Unemployment Insurance Act is generally taxable - unless it is for an injury sustained on the job.
For further information on how disability insurance proceeds are taxed, and see IRS Publication 525 - Taxable and Non-Taxable Income: http://www.irs.gov/publications/p525/ar02.html
If you have questions or concerns on this issue, do not hesitate to call Zeiler Insurance and speak to one of our customer service representatives. As an independent agency, Zeiler Insurance prides itself with quality customer services for the people of the Chicago-land area and the rest of the Midwest. Customer or not, we can review your insurance and see if you are being protected appropriately for the right price.
(708) 597-5900 X134